Important points
- The unprofitable companies in the Russell 2000 have outperformed those within the same index that are profitable.
- Some investors believe that small-cap stocks have room for growth, citing their relative affordability and expectations for improved earnings.
Bubbles are noticeable in the U.S. stock market, especially among small and medium-sized enterprises.
This week, the Russell 2000 index achieved a new high, outperforming the S&P 500 since its low in April. Optimism around potential interest rate cuts has contributed to expectations that small-cap stocks—typically those valued between $250 million and $2 billion—will continue their upward trend.
Yet, while there’s excitement, some investors express concerns. Unprofitable companies in the Russell 2000 have risen about 19% this year until October 21, which is over double the 9% gain for their profitable counterparts, according to Oren Silan, who manages the Lazard U.S. Systematic Small-Cap ETF. In comparison, the S&P 600, a small-cap index aiming for positive returns, is only up about 2% since the start of the year, which falls short of yields on low-risk CDs.
Silan noted in a conversation with Investopedia that the anticipation of lower interest rates—often beneficial for small and medium businesses—might have sparked this speculative rally. Despite recent cuts by the Fed, Chairman Jerome Powell has moderated expectations for further reductions, yet market participants still foresee additional cuts.
Why this matters to investors
Although the small-cap bull market has been relatively brief in recent years, experts focusing on this segment feel more confident that these companies could outperform larger ones.
Even amid this speculative surge, fund managers continue to support small-cap stocks. They are expected to exhibit stronger earnings growth, even though their earnings have remained somewhat static in the past couple of years.
Moreover, small-cap valuations remained reasonably appealing at the end of Q3, despite their increase since April. Evidence supports this: the Russell 2000’s total market cap accounts for 4.4% of the overall Russell 3000, significantly lower than the historical average of 7.6% since late 1984. Additionally, valuations for small-cap stocks relative to large-cap stocks—assessed by enterprise value against earnings before interest and taxes (excluding companies that are unprofitable)—are among the lowest seen in 25 years. Projections suggest Russell 2000 companies could see earnings grow by over 25% in 2025, significantly outpacing the Russell 1000’s expected 10% growth.
A robust U.S. economy typically favors small and medium enterprises, which often rely less on international markets. Francis Gannon, co-CIO at Royce, highlighted in a recent quarterly report that while there are concerns—such as negative employment data, weak consumer confidence, and lackluster manufacturing statistics—consumer spending is ongoing, the economy is expanding, and lower interest rates are easing capital access.
Concerns regarding small-cap stocks largely mirror those for stocks overall, especially as indexes reach all-time highs. However, unlike large-cap stocks, small-cap ones have been somewhat overlooked in recent times. According to the mean reversion theory, if past asset prices and returns align with long-term averages, small-cap stocks should maintain their upward trend.
